Rational and near-rational bubbles without drift
By: Kevin J. Lansing
Contributors: Federal Reserve Bank of San Francisco
Series: FRBSF working paper -- 2007-10; FRBSF working paper (Online) -- #2007-10.
Publisher: Federal Reserve Bank of San Francisco
Published: 2007
Place of publication: San Francisco]
Language: eng
Format: [electronic resource] /
Description: This paper derives a general class of intrinsic rational bubble solutions in a standard  Lucas-type asset pricing model. I show that the rational bubble component of the price-dividend ratio can evolve as a geometric random walk without drift. The volatility of  bubble innovations depends exclusively on fundamentals. Starting from an arbitrarily  small positive value, the rational bubble expands and contracts over time in an irregular,  wholly endogenous fashion, always returning to the vicinity of the fundamental solution.  I also examine a near-rational solution in which the representative agent does not construct separate forecasts for the fundamental and bubble components of the asset price.  Rather, the agent constructs only a single forecast for the total asset price that is based  on a geometric random walk without drift. The agent's forecast rule is parameterized to  match the moments of observable data. In equilibrium, the actual law of motion for the  price-dividend ratio is stationary, highly persistent, and nonlinear. The agent's forecast  errors exhibit near-zero autocorrelation at all lags, making it difficult for the agent to  detect a misspecification of the forecast rule. Unlike a rational bubble, the near-rational  solution allows the asset price to occasionally dip below its fundamental value. Under mild  risk aversion, the near-rational solution generates pronounced low-frequency swings in the  price-dividend ratio, positive skewness, excess kurtosis, and time-varying volatility--all of  which are present in long-run U.S. stock market data. An independent contribution of  the paper is to demonstrate an approximate analytical solution for the fundamental asset  price that employs a nonlinear change of variables.
Notes: Title from PDF file (viewed on Sept. 13, 2007).

"May 2007."

Includes bibliographical references.

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